Elliott wave principle
The Elliott wave principle is a form of technical analysis that some traders use to analyze financial market cycles and forecast market trends by identifying extremes in investor psychology, highs and lows in prices, and other collective factors. Ralph Nelson Elliott (1871–1948), a professional accountant, discovered the underlying social principles and developed the analytical tools in the 1930s. He proposed that market prices unfold in specific patterns, which practitioners today call Elliott waves, or simply waves. Elliott published his theory of market behavior in the book The Wave Principle in 1938, summarized it in a series of articles in Financial World magazine in 1939, and covered it most comprehensively in his final major work, Nature’s Laws: The Secret of the Universe in 1946. Elliott stated that "because man is subject to rhythmical procedure, calculations having to do with his activities can be projected far into the future with a justification and certainty heretofore unattainable." The empirical validity of the Elliott Wave Principle remains the subject of debate. Overall design The Elliott Wave Principle posits that collective investor psychology, or crowd psychology, moves between optimism and pessimism in natural sequences. These mood swings create patterns evidenced in the price movements of markets at every degree of trend or time scale. In Elliott's model, market prices alternate between an impulsive, or motive phase, and a corrective phase on all time scales of trend, as the illustration shows. Impulses are always subdivided into a set of 5 lower-degree waves, alternating again between motive and corrective character, so that waves 1, 3, and 5 are impulses, and waves 2 and 4 are smaller retraces of waves 1 and 3. Corrective waves subdivide into 3 smaller-degree waves starting with a five-wave counter-trend impulse, a retrace, and another impulse. In a bear market the dominant trend is downward, so the pattern is reversed—five waves down and three up. Motive waves always move with the trend, while corrective waves move against it. Degree The patterns link to form five and three-wave structures which themselves underlie self-similar wave structures of increasing size or higher degree. Note the lower most of the three idealized cycles. In the first small five-wave sequence, waves 1, 3 and 5 are motive, while waves 2 and 4 are corrective. This signals that the movement of the wave one degree higher is upward. It also signals the start of the first small three-wave corrective sequence. After the initial five waves up and three waves down, the sequence begins again and the self-similar fractal geometry begins to unfold according to the five and three-wave structure which it underlies one degree higher. The completed motive pattern includes 89 waves, followed by a completed corrective pattern of 55 waves. Each degree of a pattern in a financial market has a name. Practitioners use symbols for each wave to indicate both function and degree—numbers for motive waves, letters for corrective waves (shown in the highest of the three idealized series of wave structures or degrees). Degrees are relative; they are defined by form, not by absolute size or duration. Waves of the same degree may be of very different size and/or duration. The classification of a wave at any particular degree can vary, though practitioners generally agree on the standard order of degrees (approximate durations given): *Grand supercycle: multi-century *Supercycle: multi-decade (about 40–70 years) *Cycle: one year to several years (or even several decades under an Elliott Extension) *Primary: a few months to a couple of years *Intermediate: weeks to months *Minor: weeks *Minute: days *Minuette: hours *Subminuette: minutes Elliott Wave personality and characteristics Elliott wave analysts (or Elliotticians) hold that each individual wave has its own signature or characteristic, which typically reflects the psychology of the moment. Understanding those personalities is key to the application of the Wave Principle; they are defined below. (Definitions assume a bull market in equities; the characteristics apply in reverse in bear markets.) Pattern recognition and fractals Elliott's market model relies heavily on looking at price charts. Practitioners study developing trends to distinguish the waves and wave structures, and discern what prices may do next; thus the application of the wave principle is a form of pattern recognition. The structures Elliott described also meet the common definition of a fractal (self-similar patterns appearing at every degree of trend). Elliott wave practitioners say that just as naturally-occurring fractals often expand and grow more complex over time, the model shows that collective human psychology develops in natural patterns, via buying and selling decisions reflected in market prices: "It's as though we are somehow programmed by mathematics. Seashell, galaxy, snowflake or human: we're all bound by the same order."John Casti (31 August 2002). "I know what you'll do next summer". New Scientist, p. 29. Elliott wave rules and guidelines A correct Elliott wave "count" must observe three rules: # Wave 2 never retraces more than 100% of wave 1. # Wave 3 cannot be the shortest of the three impulse waves, namely waves 1, 3 and 5. # Wave 4 does not overlap with the price territory of wave 1, except in the rare case of a diagonal triangle. A common guideline observes that in a five-wave pattern, waves 2 and 4 will often take alternate forms; a sharp move in wave 2, for example, will suggest a mild move in wave 4. Corrective wave patterns unfold in forms known as zigzags, flats, or triangles. In turn these corrective patterns can come together to form more complex corrections. Similarly, a triangular corrective pattern is formed usually in wave 4 (very rarely in wave 2) and is the indication of end of correction. Fibonacci relationships R. N. Elliott's analysis of the mathematical properties of waves and patterns eventually led him to conclude that "The Fibonacci Summation Series is the basis of The Wave Principle". Numbers from the Fibonacci sequence surface repeatedly in Elliott wave structures, including motive waves (1, 3, 5), a single full cycle (8 waves), and the completed motive (89 waves) and corrective (55 waves) patterns. Elliott developed his market model before he realized that it reflects the Fibonacci sequence. "When I discovered The Wave Principle action of market trends, I had never heard of either the Fibonacci Series or the Pythagorean Diagram". The Fibonacci sequence is also closely connected to the Golden ratio (1.618). Practitioners commonly use this ratio and related ratios to establish support and resistance levels for market waves, namely the price points which help define the parameters of a trend.Alex Douglas, "Fibonacci: The man & the markets," Standard & Poor's Economic Research Paper, February 20, 2001, pp. 8–10. PDF document here See Fibonacci retracement. Finance professor Roy Batchelor and researcher Richard Ramyar, a former Director of the United Kingdom Society of Technical Analysts and formerly Global Head of Research at Lipper and Thomson Reuters Wealth Management, studied whether Fibonacci ratios appear non-randomly in the stock market, as Elliott's model predicts. The researchers said the "idea that prices retrace to a Fibonacci ratio or round fraction of the previous trend clearly lacks any scientific rationale". They also said "there is no significant difference between the frequencies with which price and time ratios occur in cycles in the Dow Jones Industrial Average, and frequencies which we would expect to occur at random in such a time series".Roy Batchelor and Richard Ramyar, "Magic numbers in the Dow," 25th International Symposium on Forecasting, 2005, p. 13, 31. PDF document here Robert Prechter replied to the Batchelor–Ramyar study, saying that it "does not challenge the validity of any aspect of the Wave Principle...it supports wave theorists' observations," and that because the authors had examined ratios between prices achieved in filtered trends rather than Elliott waves, "their method does not address actual claims by wave theorists".Robert Prechter (2006), "Elliott Waves, Fibonacci, and Statistics," p. 2. PDF document here The Socionomics Institute also reviewed data in the Batchelor–Ramyar study, and said these data show "Fibonacci ratios do occur more often in the stock market than would be expected in a random environment".Deepak Goel (2006), "Another Look at Fibonacci Statistics". PDF document here Extracted from the same relationship between Elliott Waves and Fibbonacci ratio, a 78.6% retracement level is identified as a best place for buying or selling (in continuation to the larger trend) as it increases the risk to reward ratio up to 1:3. It has been suggested that Fibonacci relationships are not the only irrational number based relationships evident in waves.(2011), "Evidence of the silver ratio in financial market time series data". ;Example of the Elliott Wave Principle and the Fibonacci relationship The GBP/JPY currency chart gives an example of a fourth wave retracement apparently halting between the 38.2% and 50.0% Fibonacci retracements of a completed third wave. The chart also highlights how the Elliott Wave Principle works well with other technical analysis tendencies as prior support (the bottom of wave-1) acts as resistance to wave-4. The wave count depicted in the chart would be invalidated if GBP/JPY moves above or even touches the wave-1 low. After Elliott Following Elliott's death in 1948, other market technicians and financial professionals continued to use the wave principle and provide forecasts to investors. Charles Collins, who had published Elliott's "Wave Principle" and helped introduce Elliott's theory to Wall Street, ranked Elliott's contributions to technical analysis on a level with Charles Dow. Hamilton Bolton, founder of The Bank Credit Analyst, provided wave analysis to a wide readership in the 1950s and 1960s. Bolton introduced the Elliott's wave principle to A.J. Frost, who provided weekly financial commentary on the Financial News Network in the 1980s. Frost co-authored Elliott Wave Principle with Robert Prechter in 1978. Rediscovery and current use Robert Prechter came across Elliott's works while working as a market technician at Merrill Lynch. His prominence as a forecaster during the bull market of the 1980s brought the greatest exposure to date to Elliott's work, and today Prechter remains the most widely known Elliott analyst. Among market technicians, wave analysis is widely accepted as a component of their trade. Elliott's Wave principle is among the methods included on the exam that analysts must pass to earn the Chartered Market Technician (CMT) designation, the professional accreditation developed by the Market Technicians Association (MTA). Robin Wilkin, Ex-Global Head of FX and Commodity Technical Strategy at JPMorgan Chase, says "the Elliott Wave principle ... provides a probability framework as to when to enter a particular market and where to get out, whether for a profit or a loss."Robin Wilkin, Riding the Waves: Applying Elliott Wave Theory to the Financial and Commodity Markets The Alchemist June 2006 Jordan Kotick, Global Head of Technical Strategy at Barclays Capital and past President of the Market Technicians Association, has said that R. N. Elliott's "discovery was well ahead of its time. In fact, over the last decade or two, many prominent academics have embraced Elliott’s idea and have been aggressively advocating the existence of financial market fractals."Jordan Kotick, An Introduction to the Elliott Wave Principle The Alchemist November 2005 One such academic is the physicist Didier Sornette, professor at ETH Zurich. In a paper he co-authored in 1996 ("Stock Market Crashes, Precursors and Replicas") Sornette said, Paul Tudor Jones, the billionaire commodity trader, calls Prechter and Frost's standard text on Elliott "a classic," and one of "the four Bibles of the business": Criticism The premise that markets unfold in recognizable patterns contradicts the efficient market hypothesis, which states that prices cannot be predicted from market data such as moving averages and volume. By this reasoning, if successful market forecasts were possible, investors would buy (or sell) when the method predicted a price increase (or decrease), to the point that prices would rise (or fall) immediately, thus destroying the profitability and predictive power of the method. In efficient markets, knowledge of the Elliott Wave Principle among traders would lead to the disappearance of the very patterns they tried to anticipate, rendering the method, and all forms of technical analysis, useless. Benoit Mandelbrot has questioned whether Elliott waves can predict financial markets: Robert Prechter had previously stated that ideas in an article by MandelbrotMandelbrot, Benoit (February 1999). Scientific American, p. 70. "originated with Ralph Nelson Elliott, who put them forth more comprehensively and more accurately with respect to real-world markets in his 1938 book The Wave Principle."Details here. Critics also warn the wave principle is too vague to be useful, since it cannot consistently identify when a wave begins or ends, and that Elliott wave forecasts are prone to subjective revision. Some who advocate technical analysis of markets have questioned the value of Elliott wave analysis. Technical analyst David Aronson wrote:Aronson, David R. (2006). [http://www.wiley.com/WileyCDA/WileyTitle/productCd-0470008741,descCd-authorInfo.html Evidence-Based Technical Analysis], Hoboken, New Jersey: John Wiley and Sons, p. 61. ISBN 978-0-470-00874-4. See also * Behavioral economics * Business cycle * The Wisdom of Crowds Notes References * Elliott Wave Principle: Key to Market Behavior by A.J. Frost & Robert R. Prechter, Jr. Published by New Classics Library. ISBN 978-0-932750-75-4 *''Mastering Elliott Wave: Presenting the Neely Method: The First Scientific, Objective Approach to Market Forecasting with Elliott Wave Theory'' by Glenn Neely with Eric Hall. Published by Windsor Books. ISBN 0-930233-44-1 * Applying Elliott Wave Theory Profitably by Steven W. Poser. Published by John Wiley & Sons, Ltd. ISBN 0-471-42007-7 * R.N. Elliott's Masterworks by R.N. Elliott, edited by Robert R. Prechter, Jr. Published by New Classics Library. ISBN 978-0-932750-76-1 * Elliott Wave Principle Applied to the Foreign Exchange Markets by Robert Balan. Published by BBS Publications, Ltd. * Elliott Wave Explained by Robert C. Beckman. Published by Orient Paperbacks. ISBN 978-81-7094-532-1 * Harmonic Elliott Wave: The Case for Modification of R.N. Elliott's Impulsive Wave Structure by Ian Copsey, Published by John Wiley & Sons. ISBN 978-0-470-82870-0 External links *investorwords.com glossary - Elliott Wave Theory *Elliott Wave International - What Is the Wave Principle? Category:Technical analysis Category:Crowd psychology